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Innovative ETFs Mask Hidden Risks

John Gorlow | Dec 09, 2015

Over the past decade, Exchange Traded Funds (ETFs) have grown to become one of the most popular products in Wall Street history. An ETF is a security that tracks an index, commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, ETFs trade like a common stock with prices changing throughout the day as they’re bought and sold. 

 

Compared to mutual funds, ETFs tout low fees, intra-day liquidity (mutual fund transactions are settled only at the end of the day) and the promise of being able to buy or sell on demand. But in times of high volatility, the ETF industry has been unable to keep its liquidity promise and may even exacerbate head-spinning market downturns.

 

How do ETFs work?

 

With conventional mutual funds, investors lay down their cash (or shares) to move into or out of a fund at net asset value. At the end of the trading day, the fund matches buy and sell orders, then reconciles any difference by buying or selling additional shares in the marketplace. Everyone gets the same net price.

 

Like any passive or index mutual fund, exchange-traded funds (ETFs) aim to replicate the performance of the index they track. But ETFs manage share creation and redemption very differently, through “in kind” arrangements between the fund and Authorized Participants (specialists and market makers).

 

To create shares, a basket of portfolio securities is deposited with the ETF by an Authorized Participant in exchange for fund shares. Shares can then be sold by the Authorized Participant through any broker-dealer, who in turn sells those shares to cash-paying customers. Cash proceeds then flow from the broker-dealer back to the Authorized Participant or to a separate market maker. When funds are redeemed, the process is reversed.

 

In an efficient market, the price of an ETF, like any derivative, should equal the price of its underlying portfolio. The fact that new shares can be created and redeemed almost continuously by Authorized Participants enables an arbitrage process that, in theory at least, keeps ETF share prices in alignment with their net asset values (NAV). However, due to their popularity among investors for speculative and hedging purposes, ETFs are increasingly exposed to non-news driven supply and demand shocks. If the arbitrage process undertaken by the Authorized Participants fails, these shocks can be transmitted to the underlying securities, causing prices to rise and fall for no apparent fundamental reason. And because ETF share prices are determined by demand and supply in the secondary market, a fund’s price can diverge significantly from the value of its underlying shares. 

 

Let’s look at some real-life experiences involving ETFs.

 

ETFs Fall Hard in May 2010 Flash Crash

 

On the afternoon of May 6, 2010, U.S. equity market indices went into an inexplicable tailspin, falling 10% in a matter of minutes. The Dow Jones Industrial Average (DJIA) fell nearly 1,000 points, its sharpest intraday drop in history, then roared back to recover 600 points within 20 minutes.

 

Procter & Gamble dropped an astounding 25%, and as questions swirled about pricing of individual stocks, some of the biggest ETF arbitragers—the Authorized Participants—pulled back from trading. This affected ETFs from every major provider, including iShares, Power Shares, Russell, Rydex, Schwab, State Street, Wisdom Tree and Vanguard.

 

For those holding ETFs the ride was rough. Some 27% of the 838 ETFs existing at that time imploded, becoming unhinged from their underlying securities pricing. The iShares Russell 2000 value index ETF (ticker: IWN) plunged from around $66 per share to only 11 cents in an instant. The iShares Dow Jones Select Dividend Index ETF (ticker: DVY) fell 63% intraday. And the Vanguard Growth ETF (ticker: VUG) lost an incredible 99% of its value.

 

The exchanges ultimately canceled trades at prices below 60% of the 2:40 p.m. (EDT) price, but the damage was considerable. Many retail investors with stop loss orders had ETF orders executed at prices well below the day’s earlier high market levels. Professionals got caught too, particularly those who bought at bargain basement prices and hedged by short-selling, only to see their long positions canceled and assets rebound.

 

It’s noteworthy that ETFs accounted for 70% of the equity transactions that were canceled. Of 227 ETFs that had trades stopped because their price declined 60% or more, 160 fell to nearly zero. These included some of the largest and most widely held issues in the ETF category.

 

ETFs Can’t Take the Heat in August 2015 Market Slide

 

As markets opened on Monday, Aug. 24, 2015, U.S. stocks were under heavy selling pressure and the ETF marketplace was once again tested. Investor confidence was further dented by what happened next. While the S&P 500 fell as much as 5.3% in the opening minutes of trading, the $65 billion iShares Core S&P 500 ETF (ticker: IVV) fell as much as 26%, some 20 percentage points below its fair value. Disorderly trading affected big ETFs from every major provider. According to Barron’s, the $18 billion Vanguard Dividend Appreciation ETF (VIG) and the $12 billion SPDR S&P Dividend (SDY) plunged 38% apiece, while the Power Shares S&P 500 Low Volatility ETF (SPLV) fell as much as 46% before clawing back an hour after markets opened. In the end, 327 ETFs were hit with five-minute trading halts. Eleven were halted 10 or more times, according to TD Ameritrade.

 

Cautionary Advice on ETF Risks

 

Researchers and industry experts are now studying the unintended consequences and systemic risks of ETFs. The SEC’s Division of Trading and Markets has raised important questions for public comment, specific to the listing and trading of ETFs, arbitrage and market pricing, broker-dealer sales practices, and investor understanding of the products. Following are non-attributed comments pulled from a detailed response to the SEC request:

 

  • The 1929 market crash, the dot-com bubble, mortgage-backed securities crisis, the financial crisis of 2008 and the current China market crisis all stemmed from hazardous over-leveraging.

     

  • The data shows many ETFs along with their underlying assets are illiquid. Some subsets of ETFs continue to grow in number when the liquidity only resides within very few securities. Leverage across various ETFs appears to be at dangerous levels, which could become apparent in the next financial downturn. In many respects, ETFs today resemble the over-leveraged risks that have created the past significant financial crises.

     

  • In many cases, asset creations are not occurring and creations/redemptions are working in ways not expected or advertised for certain types of ETFs. Some products’ prices have moved in the opposite direction of their stated goals in temporary stressed market conditions and have even collapsed.

     

  • Short selling is extreme in many ETFs. The lending markets are not being properly utilized to accommodate the selling, causing systemic risk from undisclosed leverage in the financial system (more shares sold than exist) for the benefit of very few while creating risks for all stakeholders, including taxpayers.

     

  • $50 million is a commonly recognized asset level at which an ETF becomes profitable. There are 720 ETFs, or 43% of those trading in the U.S., below this threshold of sustainability, suggesting that even a limited amount of stress could cause these ETFs to fail.

     

  • The documentation, data, disclosures and prospectuses obtained by regulators and available to investors are not disclosing the extent of the excessive risks in these products. There appear to be significant omissions of material facts by some ETF operators.

     

  • U.S. blue chip companies are underlying assets for a significant number of ETFs. The interconnection of the growing number of derivative products based on the same assets suggests in a crisis market, significant stresses from these interconnected products may reverberate throughout the heart of the U.S. financial system.

 

It’s not just the SEC asking questions. One leading issuer was recently the subject of a pension fund lawsuit for diverting excessive security lending revenue to an affiliate rather than retaining it for fund shareholders.In essence, this leaves shareholders shouldering risk without sufficient compensation to match.  

 

The Wall Street Journal recently chimed in with ETF advice in a December 6th article titled Should You Fear the EFT?  Questions included whether ETFs have enough safeguards, whether investors really need them, and if the EFT meltdown of August 2015 could happen again. Even Vanguard issued a Best Practices for ETF Trading: Seven Rules of the Road a cautionary approach for investors who use these products.

 

When global regulators, sophisticated investors and respected members of the securities industry all raise red flags about a financial product, it’s time to pay attention.

 

The ETF Machine

 

And yet the popularity of ETFs continues to grow, fueled by aggressive advertising. Between the Flash Crash of May 2010 and the end of 2014, the number of registered U.S. ETFs nearly doubled from 838 to 1,663, with an aggregate market capitalization of over $2 trillion. In 2014, trading in U.S.-listed ETFs made up about 25.7% of U.S. equity trading by dollar volume. Think about that for a moment: 25% of total equity trading value is in the hands of a volatile financial instrument that has not performed well under duress. 

 

ETFs lure investors through the promise of lower costs and greater liquidity. But there is a great deal of risk that hasn’t been addressed. ETFs are based on an assumption that operators and Authorized Participants will create shares and assets as expected (in fact, they have no obligation to do so).

 

Howard Marks of Oaktree Capital Management asks, “Will ETFs prove liquid in the next crisis? And what impact will mass sales of ETFs have on the prices of their underlying assets? We will find out.” Like others, he makes the point that no investment vehicle should promise greater liquidity than is afforded by its underlying assets. ETFs are built on potentially illiquid assets that may be hard to sell or value in any market, but especially in turbulent markets. We’ve already had a taste of what happens when ETFs disconnect from underlying assets, and it isn’t good

ETFs shouldn’t be ignored, and they’re clearly useful in some situations. At Cardiff Park Advisors, we sometimes mix DFA passive funds and Vanguard traditional index funds with selected ETF offerings. Used appropriately, ETFs can be a valuable part of one’s portfolio. But as in all investments, it’s best to be well informed and aware of potential risks.